How To Use Market Sentiment To Improve Your Trading/Investing (Part 2)

Last week, I began with the premise that tracking sentiment is a much more accurate way to determine the direction, or change in direction of a market, relative to fundamental analysis.  This week, I will outline the shortcomings of fundamental analysis, and follow up next week with how we track sentiment to identify potential changes in direction within a market.

Fundamental analysis is generally defined as a method of evaluation that attempts to measure “value” by examining related “current” economic, financial and other qualitative and quantitative factors. Fundamental analysts will utilize “current” macroeconomic factors (like the overall economy and industry conditions) and company-specific factors (like financial condition and management).

Therefore, market fundamentals are the existing conditions of a market based upon historical data. In order to utilize this information for predictive purposes, economists will employ a form of trend extrapolation. This effectively presumes that the current market conditions will continue indefinitely into the future, until they do not. This is possibly the crudest form of linear extrapolation. But, can it really foresee turning points in a non-linear environment? If we wait for the underlying “fundamentals” to change, are we not already within a different trend within the market that is now changing underlying fundamentals?

The common perception in the market is that the news causes changes in market psychology and fundamentals, which then causes changes in stock prices. But I believe that the correct, more consistently applicable premise is that market psychology and sentiment are the causes of news events and changes in stock prices, whereas fundamentals are purely lagging indicators, and the result of psychology and sentiment changes.

Bernard Baruch, an exceptionally successful American financier and stock market speculator who lived from 1870– 1965, identified the following long ago:

“All economic movements, by their very nature, are motivated by crowd psychology. Without due recognition of crowd-thinking ... our theories of economics leave much to be desired. ... It has always seemed to me that the periodic madness which afflicts mankind must reflect some deeply rooted trait in human nature — a trait akin to the force that motivates the migration of birds or the rush of lemmings to the sea ... It is a force wholly impalpable ... yet, knowledge of it is necessary to right judgments on passing events. “

During his tenure as chairman of the Federal Reserve, Alan Greenspan testified many times before various committees of Congress. In front of the Joint Economic Committee, Green- span noted that markets are driven by “human psychology” and “waves of optimism and pessimism.” Ultimately, as Greenspan correctly recognized, it is social mood and sentiment that moves markets. I believe this makes much more sense when deriving the causality chain.

During a negative sentiment trend, the stock market declines, and the news seems to get worse and worse. Once the negative sentiment has run its course, however, and it’s time for sentiment to change direction, the general public then becomes subconsciously more positive.

When people become positive about their future, they are willing to take risks.  What is the most immediate way that the public can act on this return to positive sentiment? The easiest is to buy stocks. For this reason, we see the stock market lead in the opposite direction before the economy and fundamentals have turned. This is why R.N. Elliott, whose work led to Elliott wave theory, believed that the stock market is the best barometer of public sentiment.

Let’s look at the same change in positive sentiment and what it takes to have an effect on the fundamentals. When the general public’s sentiment turns positive, this is the point at which they are willing to take more risks based on their positive feelings about the future. Whereas investors immediately place money to work in the stock market, having an immediate affect upon stock prices, business owners and entrepreneurs seek loans to build or expand a business, which take time to secure. They then place the newly acquired funds to work in their business by hiring more people or buying additional equipment, and this takes more time. With this new capacity, they are then able to provide more goods and services to the public, and, ultimately, profits and earnings begin to grow — after more time has passed.

When the news of such improved earnings finally hits the market, most market participants seem shocked that the stock starts to move up strongly (even though the stock likely bottomed well before the public takes notice when the investors effectuated their positive sentiment by buying stock), and they simply attribute the stock’s rise to the announcement of positive earnings. 

There is a significant lag between a positive turn in public sentiment and the resulting change in the fundamentals of a stock or the economy, especially relative to the more immediate stock-buying activity that comes from the sentiment change. This is why fundamentalists can be left holding the bag at the top of a market, when the news and fundamentals look the most attractive, right before the market begins to dive, as sentiment turns in the opposite direction well before the fundamentals.

This lag is a much more plausible reason as to why the stock market is a leading indicator, as opposed to some form of investor omniscience. This also provides a plausible reason as to why earnings lag stock prices, as earnings are the last segment in the chain of positive mood effects on a business growth cycle. It is also why those analysts who attempt to predict stock prices based on earnings fail so miserably. By the time earnings are affected by a change in social mood, the social mood trend has already been negative for some time. And this is why economists fail as well — the social mood has shifted well before they see evidence of it in their “indicators.”

In 1996, Robert Olson published a study in the Financial Analysts Journal in which he studied the effects of herding upon “expert” fundamental analysts’ predictions of corporate earnings. After studying 4000 corporate earnings estimates, he arrived at the following conclusion:

“Experts’ earnings predictions exhibit positive bias and disappointing accuracy. These shortcomings are usually attributed to some combination of incomplete knowledge, incompetence, and/or misrepresentation.”

Mr. Olson’s article suggests that “the human desire for consensus leads to herding behavior among earnings forecasters,” with the herd always looking for the current trend to continue unabated and indefinitely.  But, those that have experience in the non-linear work of the stock market understand that the most bullish calls by these “expert fundamentalists” almost always come at the top of a market or stock.

Next week, I will provide you with an overview of Elliott Wave analysis, and how we use it to identify changes in market direction before markets turn.

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Courtesy of ElliottWaveTrader.net